For online lenders, Wall Street cash brings growth and risk

SAN FRANCISCO (Reuters) - Institutional investors are tripping over themselves to buy so-called peer-to-peer loans offered by a new breed of Internet lending companies, a development that could transform the nascent sector into significant player in the credit markets.

A street sign for Wall Street hangs in front of the New York Stock Exchange May 8, 2013. REUTERS/Lucas Jackson

P2P lending, as it is known, started in 2006 with the founding of Lending Club and Prosper Marketplace. Back then, the idea was to match individual borrowers with small investors looking to lend as little as $25.

The loans often have interest rates low enough to make them a feasible way for individuals to pay off high-cost credit card debt, yet the returns to investors are attractive compared to many other fixed-income assets.

These developments have caught the eye of hedge funds, endowments, pension funds and even banks and insurers who want to put hundreds of millions of dollars to work.

The influx of institutional money is enabling online lenders, led by Lending Club and Prosper, to offer far more loans and compete more directly with traditional banks. Loan originations are growing at about 300 percent a year, according to the two market leaders.

But the arrival of Wall Street investors also brings new risks for the sector. Sharp changes in interest rates or another economic slump could prompt the new money to depart as quickly as it arrived. And questions remain about the way the peer-to-peer lending industry vets borrowers and whether interest rates on the loans properly reflect the risk.

“The industry says it’s more efficient and it uses technology to underwrite better. That’s all a bunch of crap,” said Mike Cagney, a credit market veteran and founder of SoFi, an Internet lending platform focused on student loans. “Peer-to-peer lending in its current form hasn’t really gone through a full credit crisis.”

Lending Club and Prosper do not lend money directly. Instead, borrowers fill out loan applications and post requests on their websites. Investors commit to fund the loans, then Utah-based bank WebBank makes the loans, sells them to Lending Club and Prosper, which in turn sell them on to the investors in the form of a note. The companies make money from servicing and origination fees.

The industry is on course to make about $3 billion in loans this year. But the market opportunity is about $85 billion, based on the most creditworthy borrowers currently served by the credit card industry, Prosper executive Ron Suber told a packed crowd at the industry’s first conference, LendIt, last month.

Google Inc took a $125 million stake in Lending Club in May, valuing the company at more than $1.5 billion. An initial public offering is planned next year, according to Lending Club Chief Executive Renaud Laplanche.

‘ATTRACTIVE YIELD’

P2P loans have annual interest rates ranging from 6 percent to as much as 30 percent, higher than many other fixed-income assets. The loans are typically repaid after just over a year.

“Attractive yield and short duration. In a yield-starved world, it’s very interesting,” said Jason Jones of private investment firm Disruption Credit, which is starting a fund to buy and possibly securitize P2P loans.

Other investment funds that are jumping into the business include HCG Funds, which recently launched a $10 million fund for Lending Club loans; Colchis Capital, which has more than $200 million allocated to P2P loan investing; and Eaglewood Capital Management and Arcadia Funds.

A new Internet lending site, CircleBack Lending, will launch this month with an exclusive focus on institutions and ultra-wealthy investors, according to co-founder Michael Solomon.

Some institutional loan buyers employ leverage - borrowing money at a lower interest rate and then re-lending it to the online borrowers.

Disruption Credit, according to Jones, is planning to raise a $75 million fund to invest in P2P loans, and will then borrow another $425 million so it can buy $500 million worth of loans.

Eaglewood, which has put about $80 million to work in P2P lending so far, can leverage its fund 3 to 1, depending on the risk of the loans and other criteria.

But counting on money from leveraged hedge funds could leave the industry suddenly starved of funds to lend in the event that rising interest rates, a slumping economy or unexpectedly high rates of default were to suddenly send that money elsewhere.

The credit risk is hardly academic: loans originated by Prosper from November 2005 to June 2009 had a yield of just over 12 percent through the end of 2012. But losses from loan defaults reached almost 18 percent, leaving investors down 5.36 percent overall.

Prosper now sets interest rates on loans itself, based on the creditworthiness of borrowers, a big change from letting borrowers and lenders negotiate rates and an approach it says that has helped the company attract institutional investors.

Still, the challenges of relying on leveraged investors remain for Lending Club, Prosper and new rivals like CircleBack.

“If any P2P platform becomes overly reliant on hedge funds or similar capital that is sensitive to markets and could be quickly removed, a major market shakeout could cut demand for their loans,” said Jose Penabad of HCG Funds.

Hedge funds represent less than 10 percent of funding for loans on Lending Club and only half of them use leverage, according to CEO Laplanche. Lending Club has been working to attract more stable sources of institutional funding such as corporate pension plans and community banks, he said.

And Lending Club has sought to prevent too much hedge fund money from flooding the market.

Colchis tried to launch a leveraged P2P loan fund earlier this year, but Lending Club did not allow it because the platform is not originating enough loans to meet the demand that would have been created by such an investment vehicle, according to a Colchis investor who did not want to be identified.

A Colchis representative declined to comment. Lending Club’s Laplanche confirmed that there is no leveraged Colchis fund but declined further comment.

SECURITIZATION LOOMS

Some of the new P2P investors hope to employ yet another Wall Street tactic to boost returns: securitizing the loans by slicing them up into pieces for sale.

Disruption Credit, for one, plans to securitize its loan assets in the future, dividing them into different tranches that can be bought and possibly traded by institutions such as pension funds and insurers.

Cagney said SoFi is planning the first securitization of its P2P student loans in September, with ratings from the credit rating agency DBRS and underwriting by banks including Barclays.

Securitization will provide another source of capital to fuel further growth in originations. But it also exposes the industry to even greater interest rate risk.

If yields on other types of debt jump as firms are preparing to securitize a pool of P2P loans, that could imperil the effort by making the offering less attractive to investors.

Junk bond yields have surged from less than 5 percent to almost 7 percent in recent months. That makes P2P loans relatively less attractive to investors, said Cagney.

If rates keep climbing, SoFi may have to wait to do its securitization, he added.

Meanwhile, SoFi’s loans are being financed by banks including Morgan Stanley.

“We could afford to wait a few months,” Cagney added.

(This story refiles to fix the spelling throughout of SoFi founder to Cagney from Cagny)